What Deferred Revenue Is in Accounting, and Why It's a Liability

Deferred revenue, also known as unearned revenue, refers to advance payments a company receives for products or services that are to be delivered or performed in the future. The company that receives the prepayment records the amount as deferred revenue, a liability on its balance sheet.

Deferred revenue is a liability because it reflects revenue that hasn't yet been earned and it represents products or services that are owed to a customer. It's recognized proportionally as revenue on the income statement as the product or service is delivered over time.

How Deferred Revenue Works

Deferred revenue is recognized as a liability on the balance sheet of a company that receives an advance payment because it has an obligation to the customer in the form of the products or services owed. The payment is considered a liability to the company because there's a possibility that the good or service may not be delivered or the buyer might cancel the order.

The company would have to repay the customer in either case unless other payment terms were explicitly stated in a signed contract.

Generally accepted accounting principles (GAAP) require certain accounting methods and conventions that encourage accounting conservatism that ensures that the company is reporting the lowest possible profit. A company that's reporting revenue conservatively will only recognize earned revenue when it has completed certain tasks to have full claim to the money and when the likelihood of payment is certain.

Deferred revenue is often gradually recognized on the income statement to the extent that the revenue is "earned" as a company delivers services or products. Categorizing deferred revenue as earned revenue too quickly or simply bypassing the deferred revenue account altogether and posting it directly to revenue on the income statement is considered aggressive accounting and effectively overstates sales revenue.

The portion of the payment that pertains to services or products to be provided after 12 months from the payment date should be classified as deferred revenue under the long-term liability section of the balance sheet if a customer made an up-front prepayment for services that are expected to be delivered over several years.

Example of Deferred Revenue

Deferred revenue has become more common with subscription-based products or services that require prepayments. Unearned revenue can be rent payments that are received in advance, prepayments received for newspaper subscriptions, annual prepayments received for the use of software, and prepaid insurance. 

This form of revenue has become mainstream as an annual payment to premium membership for accounts such as Amazon Prime, Zoom, Adobe, Google Suite Services, and AI-based services. All belong to this category of advanced payment and are encouraged through a discount given by the companies for annual payment versus monthly payment of these subscriptions.

Consider a media company that receives a $1,200 advance payment at the beginning of its fiscal year from a customer who's purchasing an annual newspaper subscription. Upon receipt of the payment, the company's accountant records a debit entry to the cash and cash equivalent account and a credit entry to the deferred revenue account for $1,200.

The company sends the newspaper to its customer each month and recognizes revenue as the fiscal year progresses. The accountant records a debit entry to the deferred revenue account monthly and a credit entry to the sales revenue account for $100. The entire deferred revenue balance of $1,200 has been gradually booked as revenue on the income statement at the rate of $100 per month by the end of the fiscal year. The balance is now $0 in the deferred revenue account.

The Bottom Line

Deferred revenue is recorded as such because it's money that hasn't yet been earned. The product or service in question has not yet been delivered. It's common for businesses to receive payments upfront but such payments are recognized as liabilities on balance sheets because the recipients still owe goods, services, or possibly a refund if the goods or services never are delivered.